What Is Invoice Factoring And How Does It Work?
Invoice factoring is where a business sells its unpaid commercial invoices to a third-party (a factor, or factoring company) which pays cash to purchase the business’s unpaid invoices at a discount.
This is a form of asset-based finance. It can improve a business’s cash flow, enabling it to cover its operational costs.
Invoice factoring is a symbiotic relationship: the business gets instant access to funds that would otherwise be awaiting payment, and the factor makes its money from charging the business fees.
How Invoice Factoring Works
For an invoice factoring transaction to take place, there needs to be:
- a factor – the company or financial institution that purchases unpaid invoices from the business
- a debtor – the customer who owes the business money
- an unpaid invoice – the document which shows the transaction between the debtor (customer) and the business
Here is a step-by-step guide to the process of invoice factoring – the actual advances and fees will vary depending on the arrangement you have with your factoring company.
Step 1: Invoice your customer
The business raises an invoice for goods or services sold to its commercial customer
Step 2: Sell your unpaid invoice
The business then presents this invoice for sale to the factor
Step 3: The factor pays the business
The factoring company will usually pay the business in two instalments. The first instalment is paid when the business sells the debtor’s unpaid invoice. The factor will pay the business a cash advance – up to 85% of the invoiced amount.
Step 4: The customer pays
The factor will chase up the customer for payment and the customer will pay the invoice to the factor.
Step 5: Second instalment paid to the business
Once the customer has paid the money they owe, the factor will forward the remaining amount of the invoice to the business, less any factoring fees taken by the factoring company.
How Much Does Invoice Factoring Cost?
The cost of invoice factoring depends on a number of variables. Each of the following influences the rates you will pay:
- Your industry
- Invoice amount
- Invoice payment terms
- Creditworthiness of your customers
- Stability of your business
A factor will look at these things to determine the risk. Some industries are less risky than others, for example, a construction company (where projects are often delayed) would be deemed higher risk than a logistics company with relatively straightforward payment terms.
The amount of your invoices, both how much they’re for and how many there are, is one of the most important elements determining factoring cost. A factor will generally offer a better rate the higher the volume and value of a business’s invoices.
Similarly, the length of the invoice payment terms plays a part – the shorter the terms, the better, as the factor would rather be paid sooner than later (who wouldn’t?).
A factor will often credit-check your customers. This is to assess the likelihood of them settling their invoices, as well as determining the stability of your own business.
A factoring company will look at your business’s turnover, history, how long it has been trading etc. to evaluate its stability.
There are usually two main elements to invoice factoring charges:
- The Discount Charge
- The Service Charge
The Discount Charge
You can think of this like the interest on a loan. The discount charge is applied to the cash advance the factor pays the business for the invoices – usually this is 1-3% above the base rate.
This interest is normally calculated daily following the advance and applied monthly.
The Service Charge
The service charge covers the cost of managing the business’s sales ledger and is a percentage of your turnover, typically 0.5% to 3%.
There may be other charges to watch out for, such as initial set-up costs, transaction fees, minimum usage fees or annual fees.
- Improves cash flow
- Fast access to funds – you could receive up to 85% of the unpaid invoice amount within 24 hours
- It could enable the growth of the business if funds are available for buying stock, expansion, new technology etc.
- Reduced operational costs – saves the associated administration time/ staffing costs of having to chase customers for payment and manage credit control yourself
- Asking for payment from clients can be awkward – sometimes it might be easier to let a third-party, who are distanced from your business and your customer, take on this responsibility for you
- Fees eat into your profits – if your margins are small this can be critical
- If not managed sensitively, your customer relationship could be damaged by the factoring company dealing too harshly with debtors
- Factoring could limit your ability to access funding from other financial institutions as you will not be able to use your unpaid debts as security
I sell directly to the public – can I use invoice factoring?
No. Invoice factoring is for companies who sell goods or services business-to-business.
What if my customer doesn’t pay the factor?
The course of action taken depends on your arrangement with the factoring company. If the business is responsible for customers who don’t pay, you may have the option to buy back the invoice to seek legal action against the customer, or swap the invoice for others.
I have a start-up business – can I use invoice factoring?
Yes, but the cost of invoice factoring for start-up companies is usually much higher than for well-established businesses.